The GENIUS Act, a recently enacted U.S. stablecoin law, attempts to make stablecoins a viable payment instrument by requiring that they be backed by high-quality assets and redeemable on demand at a fixed dollar value. Even with those protections, stablecoins are likely to pose risks to retail investors, borrowers and lenders, and, consequently, the financial system.
This note describes two significant sources of risk. First, despite guarantees that they can be redeemed at a fixed dollar value, stablecoins can (and do) lose value, undermining their viability as a means of payment. Second, retail investors have the option to lend their stablecoins via DeFi lending platforms in exchange for interest payments. But lenders can incur significant losses or become unable to redeem their stablecoins from DeFi lending platforms, even if the stablecoin itself is fully backed by high-quality assets. This risk arises because stablecoin borrowers primarily use the borrowed stablecoins to make highly levered purchases of crypto assets. DeFi lending platforms operate like highly levered banks. However, contrary to traditional banks, DeFi platforms do not have deposit insurance or access to a lender of last resort, nor are they held to capital or liquidity requirements or regular examination.
As a result, if stablecoins were to become more integrated into the traditional financial ecosystem, crypto market shocks could for the first time begin to have consequences for the non-crypto, “real” economy. The GENIUS Act was never intended to target these risks, and the current market structure bills under consideration would do nothing to reduce them.
Redemption Risk and Depegging Events
The GENIUS Act mandates that stablecoins be fully backed by safe and liquid assets and redeemable for a fixed amount of monetary value. However, the GENIUS Act does not prevent a stablecoin issuer from restricting the type of individuals or businesses that can redeem stablecoins, nor does it prohibit an issuer from charging fees for redemption.
Indeed, currently most stablecoin issuers, including Tether and Circle, only allow qualified institutional investors to redeem coins directly from them.[1] Without direct access to the stablecoin issuer, a retail investor typically buys and sells stablecoins on exchanges, such as Binance and Coinbase, where the price of a stablecoin can drop significantly below $1. When that happens, the coin is said to have depegged.
For the price of a stablecoin to trade around $1 per coin, institutional investors must be willing to buy coins from the exchange and redeem them from the issuer when the price drops below $1. However, in times of stress, institutional investors may be reluctant to buy coins from exchanges. This could be because they are capital-constrained and have reduced capacity to trade, or because they are afraid that the stablecoin issuer may not be able to honor its commitment to redeem stablecoins immediately for $1 per coin or simply because they are risk-averse or interested in other trades. While their function is akin to that of a market maker in securities markets, those market makers rely on customer relationships over the long term to be profitable and therefore have an incentive to continue to post a bid and ask spread. An institutional investor in stablecoins does not appear to have any similar motivation and is more akin to a high-frequency trader.
When institutional investors are unwilling or unable to buy coins and redeem them from the issuer, the coin can lose its peg to $1 and fall in value. The possibility of depegging is not just hypothetical. Indeed, we have already experienced large depegging events — one as recently as last month. Figure 1 displays two significant depegging events experienced by the largest stablecoins, USDT (issued by Tether) and USDC (issued by Circle).
Figure 1. Major depegging events.
Source: CoinGecko.
In October 2018, amid concerns about the full backing of USDT, the exchange affiliated with Tether called Bitfinex upgraded its processing systems, leading to delays in withdrawals. Investors ran on USDT, resulting in a sizable depeg as USDT traded as low as $0.90 on some platforms on Oct. 15.[2]
Similarly, USDC traded below $1 around the default of Silicon Valley Bank (SVB) in March 2023. Because USDC kept 8 percent of its reserves deposited at SVB, troubles at SVB quickly spilled over to USDC. The run on USDC started on March 9, when investors doubted Circle’s ability to access its deposits at SVB amid the bank’s imminent collapse, causing the price of USDC to trade as low as $0.87 per coin. Large USDC redemptions prompted major exchanges like Binance and Coinbase to pause USDC-to-dollars redemptions.[3] The run on the stablecoin subsided only a few days later once the FDIC, the Treasury Department and the Federal Reserve announced that the resolution of SVB would fully protect all depositors, both insured and uninsured — with Circle the largest beneficiary of this bailout.[4]
Another major depeg event occurred more recently on Oct. 10, 2025. The algorithmic stablecoin issued by Ethena Labs, USDe, often touted for its stability, temporarily traded as low as $0.65 on Binance and other exchanges due to a market selloff following news of escalation in U.S.-China trade tensions.[5] While USDe is an algorithmic stablecoin different in backing from Tether or Circle, the next section describes the systemic risk that such a depeg may pose.
One important consequence of a stablecoin depeg is that retail stablecoin holders would face significant losses if they were trying to use their coins to pay for goods and services while the coin trades below $1.
Lending Stablecoins: Risk of Losses When the Music Stops
While stablecoin issuers are forbidden to directly pay interest by the GENIUS Act, affiliates, exchanges and other third parties are paying interest on behalf of issuers, which could be a way of circumventing this prohibition.[6] But stablecoin holders can earn even more interest by lending stablecoins on DeFi platforms, such as Morpho and Aave. Under the impression fostered by the GENIUS Act that stablecoins are safe, retail investors may not hesitate to lend them out to earn interest without realizing the risks they are taking. An examination of Aave, the largest DeFi lending platform, illustrates how stablecoin lending contributes to the buildup of leverage and how stablecoin lenders can incur losses. Currently, an investor lending some of the major stablecoins (e.g., USDC and USDT) on Aave earns interest of about 4 percent, while borrowing them costs around 6 percent.[7]
Borrowings of stablecoins are collateralized by crypto assets, with a loan-to-value ratio (LTV) that varies depending on the crypto asset pledged. LTVs on Aave generally range from 60 to 90 percent. Notably, a 90 percent LTV allows for 10x leverage: with $10 of initial capital and a loan of $90, an investor can purchase crypto assets worth a total of $100 that serve as collateral to the $90 loan. Indeed, with crypto collateral worth $100 and a $90 loan, the LTV is exactly 90 percent.
Crypto speculators often borrow stablecoins, such as USDC and USDT, to take levered long positions on crypto assets. The speculator buys crypto and pledges the crypto as collateral on Aave to borrow USDT or USDC. Then, the speculator uses the borrowed stablecoins to buy more crypto, which is pledged again as collateral to raise more USDT or USDC. The leveraging process continues in a loop. Hence, the name “looper” is attached to investors that buy crypto assets with leverage.[8]
Aave allows a maximum loan-to-value ratio of 90 percent for some crypto assets.[9] The risk involved in this levered bet increases with the amount of leverage. A higher LTV amplifies gains as well as losses. Recall that in this levered bet, the collateral consists of crypto assets. Hence, if the price of a specific crypto asset drops, the collateral value declines while the loan amount remains unchanged, resulting in an increase in the LTV. If the price of the crypto asset drops enough, the new LTV could go above the liquidation threshold, currently 92 percent. To return to the required LTV level, the platform must liquidate enough collateral to pay back a significant portion of the loan. This deleveraging process could lead to cascades of fire sales as the initial collateral sale marks down the collateral value of other levered traders and leads to further liquidations — a crypto liquidation downward spiral. A liquidation spiral is not just theoretical. Indeed, on Oct. 10, 2025, total crypto liquidations approached $20 billion, a record level of crypto liquidation.[10]
Note that this downward spiral, while depressing the value of crypto assets, is necessary to keep the stablecoin loan collateralized. Table 1 depicts a stylized loan on a DeFi lending platform, such as Aave, followed by a modest 5 percent drop in the collateral value which then leads to liquidations that seek to restore the collateralization of the loan. In Panel A, Ms. Ledner has 90 USDT coins on Aave. On the other side of the platform, Mr. Hodler starts with $10 in initial equity capital and wants to take a levered long position on a crypto asset. In Panel B, Ms. Ledner lends her 90 USDT on Aave, and Mr. Hodler successfully obtains the 90 USDT loan which he uses to buy $90 worth of crypto. Now Mr. Hodler has a total of $100 worth of crypto assets, all pledged as collateral to the loan worth $90, resulting in an LTV of 90 percent. Aave sets a 92 percent liquidation threshold, so as soon as the new LTV exceeds 92 percent, liquidations take place. In Panel C, an immediate 5 percent drop in the value of crypto brings the LTV to 94.7 percent (90/95=94.7%), which is above the 92 percent liquidation threshold. The liquidation process starts and seeks to bring the LTV back to 92 percent. To do so, enough collateral must be liquidated at the new price to pay back enough of the original loan plus the liquidation bonus, so that the new loan has an LTV of 92 percent. Liquidators earn a bonus as a percentage of the debt repaid to the lender.[11] In this example, the bonus equals 2 percent. Thus, we need to find a repayment X such that
Solving for X, we get X = 42.2, and the liquidation bonus is $0.844. Thus, 42.2 USDT are returned to the lender who now has an outstanding loan worth just 47.8 USDT against collateral worth about $52, which restores the LTV to 92 percent. In other words, the liquidation process aims to keep the loan collateralized at all times. However, a large enough shock, in addition to wiping out the capital of the borrower, may also lead to losses to the lender, as we discuss next.
In Table 2 we depict a scenario in which the collateral loses enough value that the liquidation process cannot make the loan whole. With an LTV of 90 percent, the $90 loan is backed by $100 worth of collateral. If the collateral loses 20 percent of its value and goes to $80, no liquidation can return the full $90 to the lender.
Aave has an insurance fund designed to protect lenders if collateral is insufficient, but it appears to be inadequate. Aave employs a loss mutualization scheme to make lenders whole in case of losses. In case of a deficit in the collateral liquidation process (the collateral liquidation does not recover the full principal amount of the loan), the tokens staked at the insurance fund start to absorb losses. However, the fund includes Aave’s own native stablecoin. This creates classic wrong-way risk, as the Aave stablecoin presumably would lose value in case of widespread troubles at Aave itself.[12] Moreover, the insurance fund is voluntary, as token holders decide to pledge their tokens at the insurance fund in exchange for a return.[13]
Lastly, a recent change made by Aave token holders shifts the risk from borrowers to stablecoin lenders. A popular trade on Aave is to buy an algorithmic stablecoin, USDe, with the leverage obtained by pledging USDe itself as collateral for the stablecoin loan. Aave token holders voted to hardwire the value of USDe to one USDT to avoid any forced liquidation that, as discussed above, would happen if the value of the USDe collateral were to fall and the stablecoin loans were to become undercollateralized. In their words, “to mitigate the risk associated with a USDe depeg event of unnecessary liquidations, we propose hardcoding USDe’s price to USDT”, the stablecoin issued by Tether. [14] For more information on USDe, see Appendix A below.
This change shifts large amounts of risk to the stablecoin lenders, as their loans could become effectively undercollateralized without any corrective mechanism. Normally, the collateral value reflects the market value of the asset. However, Aave has fixed the collateral value of USDe to one USDT. As a result, changes in the market value of USDe are not reflected in its collateral valuation. Indeed, the market value of USDe may fall well below one USDT, as it did temporarily on Oct. 10, but instead of triggering the collateral liquidation process to restore a healthy LTV, the collateral value is artificially kept at one USDT per USDe.
The risk arises once lenders realize that their loans are undercollateralized, and try to recall or withdraw the loan. However, loans on Aave do not have a maturity, and the only way to withdraw the loan and obtain stablecoins back is if there are more stablecoins supplied to Aave than borrowed from Aave. If a significant percentage of stablecoin lenders are demanding their loans back, there will be no excess of stablecoins at Aave. At that point, the stablecoin loan will be stuck at Aave indefinitely. This means that USDT lenders who expected to be able to terminate the loan and obtain their stablecoins back could become unable to do so. This is akin to a money market fund not allowing investors to withdraw their money indefinitely.
Conclusion
An important purpose of stablecoin legislation is to transform stablecoins into a safe, regulated payment tool suitable for ordinary consumers. But without closing the loophole that enables indirect stablecoin interest payments, stablecoin legislation could give the illusion of safety while leaving consumers unprotected from runs and significant losses. Even aside from the interest payment issue, the leverage storm that characterizes stablecoin trading platforms could present a risk to the banking system as a whole. Lending on DeFi platforms could exacerbate a leverage crisis that spreads to banks and the overall financial system. Depegging prospects and redemption challenges subject both stablecoin borrowers and lenders to heightened risks. Moreover, this unstable ecosystem threatens to introduce risks that the GENIUS Act and forthcoming market structure legislation do not address: risks of crypto market shocks infecting the non-crypto economy.
Table 1. Crypto Deleveraging and Liquidations.
Table 1 displays an example of a moderate liquidation on Aave that leads to significant deleveraging but no losses to the lender. In Panel A, Ms. Ledner starts with $90 worth of USDT and Mr. Hodler with $10 worth of a generic crypto asset, called Crypto. In Panel B, we assume a loan-to-value ratio (LTV) of 90%. Ms. Ledner lends all the 90 USDT and the borrower, Mr. Hodler, takes maximum leverage. Once the USDT are lent to Aave, they become a new token called aUSDT. We also assume a 92% liquidation ratio, meaning that the liquidation is triggered when the LTV goes above 92%. In Panel C, we assume an immediate 5% drop in the value of Crypto, which triggers liquidation as the new LTV, 94.7%, is higher than the maximum allowed of 92%. The liquidation process seeks to sell enough collateral and repay enough of the loan to restore the LTV at or below the liquidation ratio. Liquidators earn a 2% bonus on the debt repaid. In other words, it has to sell $X of collateral to repay the lender so that the new loan outstanding, $90 – X, is 92% or less of the new collateral value net of liquidation bonus, $95 – 1.02X. Thus, we need to find X such that 0.92 = New Loan / New Collateral = (90-X)/(95-1.02X). Solving for X, we get X=42.2. As a result, the new loan is 90-42.2=$47.8 and the new collateral value is 95-1.02(42.2) = $52. One can indeed check that the new LTV is 0.92.
Panel A: The Beginning
Panel B: Levering Up
Panel C: Liquidations without Losses to the Lender
Table 2. Crypto Deleveraging, Liquidations and Losses to the Lender
Table 2 displays an example of a large liquidation on Aave that potentially leads to losses to the stablecoin lender. In Panel A, Ms. Ledner starts with $90 worth of USDT and Mr. Holder with $10 worth of a generic crypto asset, called Crypto. In Panel B, we assume a loan-to-value ratio (LTV) of 90%. Ms. Ledner lends all the 90 USDT and the borrower takes maximum leverage. Once the USDT are lent to Aave, they become a new token called aUSDT. We also assume a 92% liquidation ratio, meaning that the liquidation is triggered when the LTV goes above 92%. In Panel C, we assume an immediate 20% drop in the value of Crypto, which triggers liquidation as the new LTV, 112.5%, is higher than the maximum allowed of 92%. In this severe scenario, Aave liquidation bots can liquidate up to 100% of the loan and are compensated with a percentage (2%) of the debt repaid, a $1.6 liquidation bonus (2% of the collateral now valued at $80). The collateral net of liquidation penalty is worth $78.2. The liquidator can only return $78.2 out of the $90 loan to the lender and the remaining 11.8 becomes a bad debt. To pay back the bad debt, Aave can use its Umbrella fund of staked tokens, which may be insufficient to pay back the bad debt in full.
Panel A: The Beginning
Panel B: Levering Up
Panel C: The Music Stops, Liquidations Begin
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[1] The qualified institutional investors who are allowed to redeem coins directly from the issuers include crypto exchanges, large corporations and institutional traders. From Circle’s website https://www.circle.com/circle-mint under FAQs, “Circle Mint is currently available only to institutions, such as exchanges, institutional traders, wallet providers, banks, and consumer-apps companies in specific regions. Circle Mint is not available to individuals.” From Tether’s website https://tether.to/ru/redeem-tethers-to-fiat-currency, direct redemptions from Tether require a verified account and a minimum redemption of $100,000.
[2] See https://cointelegraph.com/news/untethered-the-history-of-stablecoin-tether-and-how-it-has-lost-its-1-peg.
[3] See https://www.coindesk.com/business/2023/03/11/coinbase-pauses-conversions-between-usdc-and-us-dollars-as-banking-crisis-roils-crypto.
[4] See https://www.federalreserve.gov/newsevents/pressreleases/monetary20230312b.htm
[5] See https://www.binance.com/en/trade/USDE_USDT?type=spot. Some commentators argued that the selloff of USDe on Binance was exacerbated by the fact that the exchange experienced technical difficulties (https://x.com/binance/status/1976768382012993830?t=vwRP5h2FGQrtvtx3JDC6eg&s=03) which delayed investors from buying USDe to bring the price back to $1.
[6] See for instance the Collaboration Agreement between Circle and Coinbase on page 80 of Circle’s Aug. 12, 2025, S-1 filing available at https://investor.circle.com/financials/sec-filings/.
[7] See https://app.aave.com/.
[8] See https://medium.com/timeswap/basis-trade-of-the-year-pt-susde-pt-usde-682294692973.
[9] See https://app.aave.com/reserve-overview/?underlyingAsset=0x4c9edd5852cd905f086c759e8383e09bff1e68b3&marketName=proto_mainnet_v3.
[10] See https://www.ccn.com/education/crypto/cryptos-19-billion-liquidation-explained-trump-china-tariff-leverage-crash/.
[11] For the list of liquidation bonuses by crypto asset, see https://aave.com/docs/resources/parameters.
[12] See https://aave.com/docs/aave-v3/umbrella.
[13] Data from https://app.aave.com/ and https://app.aave.com/staking/ indicates that the Umbrella fund is currently worth $340 million against Aave’s total market size of $50 billion.
[14] See https://governance.aave.com/t/arfc-susde-and-usde-price-feed-update/20495 and https://x.com/gdog97_/status/1950210209580011647.
